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The last few weeks have seen a lifting of the storm clouds that troubled financial markets in January. Critically, monetary policy is being further eased in China and the Eurozone. In China the monetary authorities have sharply raised banks’ credit allocation limits, just as they did in 2009. Meanwhile in the Eurozone the quantity of “quantitative easing” (if you will excuse the expression) has increased by a third, from €60b. a month to €80b. Meanwhile on the other side of the Atlantic the recent pace of broad money growth in the USA has been disappointing. But very low inflation makes it unlikely that the Federal Reserve will touch Fed funds rate again until June. All things considered, banking systems are in reasonable shape and the latest trends in money growth are at worst neutral for this year’s global macroeconomic prospect.Fears that monetary policy-makers are “running out of ammo” are bunkum. The last few years have seen a clear association between low growth of money and low growth of nominal gross domestic product, confirming the validity of the long-established quantity-theory-of-money propositions on the link between money and national income. As the state can always create new money by borrowing from the banking system and using the proceeds to buy something from the non-bank private sector, monetary policy can never run out of ammo. The world economy will not suffer a recession in 2016, and it would require grotesque policy errors for one to happen in 2017 or 2018. The rebound in the oil price has cheered equity markets, as the better oil price is being viewed as a pointer to demand conditions more generally. But the ultimate determinant of the change in nominal GDP is the quantity of money. Central banks should pay more attention to the money numbers than they do to the movement of one commodity, even if the commodity is as important to the world economy as oil.

Some commentators seem anxious that early 2016 feels like early 2007. But banking systems are not over-stretched and do not face heavy loan write-offs because of bad debts, while inflation is exceptionally low. Governments and central banks can readily implement expansionary policies (such as QE) if they have to. The overall prospect is for steady, if rather slow, growth of banking systems in the major countries, and so for moderate growth of broad money, and also of nominal GDP. There are worries (e.g., the oil market), but the world economy is not characterized by major macroeconomic instabilitiesIn qualification, officialdom seems committed to imposing extra capital requirements on banks across the globe, in the belief that highly-capitalised banks are safe banks and that another Great Recession could not happen if all banks were ‘safe’. Key central bankers and regulators seem not to understand that the Great Recession of 2008 – 10, like the Great Depression in the USA 1929 – 33, was caused by a collapse in the rate of change of the quantity of money. They seem further not to appreciate that the effect of tightening bank regulation will be to depress the rate of growth of the quantity of money, with wider disinflationary/deflationary consequences. Although oil prices must be expected to spike upwards at some point in the next three years (as Saudi Arabia again restricts production), underlying, ex-energy inflation will still be low/negligible in 2017 and early 2018. Money growth has turned upwards in China and India in the last few months, which argues against too much pessimism about the global outlook for 2016. A truly alarming message is that officialdom still cannot see the connections between regulatory tightening in the banking industry and weak broad money growth, and then between weak broad money growth and sluggish economic activity.

The current weekly note attachment – like the last one – is about the consequences of confusing ‘the monetary base’ and ‘the quantity of money’. This confusion has plagued commentary on both the Japanese and American economies in the last few years. (There has also quite a lot of nonsense in the UK from, for example, Liam Halligan in his Sunday Telegraph column.)In the note – which has recently appeared in Economic Affairs, a magazine published by the Institute of Economic Affairs – I recall the inflation warnings given by American monetarists in early 2009, as they bewailed the then surge in the USA’s monetary base as a result of the Federal Reserve’s asset purchases. These warnings – which were neither dated nor quantified – have so far proved silly. In fact, in the year to autumn 2013 the USA’s finished- goods producer prices index is likely to be unchanged or even to be down slightly.The failure of American monetary-base-focussed monetarism demonstrates, yet again, that the measure of money that matters in macroeconomic analysis is one that is broadly-defined to include all assets with fixed nominal value that can be used in transactions. In most countries the total of bank deposits is the best approximation to that measure of money, which has the further implication that public policy should be concerned to maintain growth of the banking system balance sheet at a low and stable rate. It should be a low rate to combat inflation, and at a steady rate to help in securing wider macroeconomic stability (i.e., stable growth of demand and output). Anyhow it is the quantity of money, not the monetary base by itself, that matters to macroeconomic outcomes.

Japan’s ‘Abenomics’ is reported to have three arrows,- a ‘revolution’ in monetary policy with ‘the Bank of Japan injecting huge amounts of “money” (whatever that means) into the economy’ (or something of the sort),- a short-term fiscal stimulus accompanied by long-term action to bring the public finances under control, and- ‘a growth strategy’ (which means in practice shaking up such over-protected parts of the Japanese economy as farming and retailing).Commentary on the last two of the three arrows has often been sceptical. Initial ‘stimulus’ (i.e., a widening of the budget deficit) is not easily reconciled with ultimate fiscal consolidation (i.e., a narrowing of the budget deficit), while Abe’s Liberal Democratic Party has drawn much of its traditional support from groups that benefit from protection and restrictive practices. By contrast, most media reporting has suggested that the Bank of Japan has definitely changed course and that a major upheaval in monetary policy is under way. This note argues that, although Japanese monetary policy has indeed shifted in an expansionary direction, the shift is far less radical than the rhetoric that has accompanied it. Japanese policy-makers and the greater part of the commentariat seem to believe that the monetary base by itself has great macroeconomic importance. This is a mistake. National income and wealth in nominal terms are a function of the quantity of money, which must be distinguished sharply from the base. Movements in the monetary base and the quantity of money may be related, but the relationship is not necessarily all that precise or reliable. It is the quantity of money, not the monetary base by itself, that matters to macroeconomic outcomes.

The rate of change in the quantity of money, broadly-defined, is the fundamental driver of the rate of change of both nominal national income and nominal national wealth. Since a nation’s wealth includes both corporate equity and the main forms of real estate (residential, commercial, rural), money trends are basic to all investment decisions.Of course the patterns of money growth vary from country to country, depending on developments in the banking system and monetary policy. This note has a quick look at the USA, Japan and the Eurozone in early 2013. I hope to expand it next week. Anyhow, to summarize, in the first half of 2013 broad money growth ran, roughly, at the following annualised rates in the three areas,4% to 5% in the USA, -3% to 4% in Japan, andlittle more than zero in the Eurozone.My verdict is that money growth rates like these are consistent with a reasonable continuing recovery in the world economy, but not with the kind of strong rebound that might be expected after the savage downturn of 2009 and the rather feeble upturn in 2010. The exception remains the Eurozone, where the reports of an improvement in recent months seem far from convincing.

More on the structural flaws of the Eurozone

The following note is in response to the call for evidence on ‘”Genuine Economic and Monetary Union” and its implications for the UK’ from the House of Lords’ European Union Committee, made on 24th April 2013.The main points of the note are

banks’ risks of future loss, and hence their need for capital to protect depositors, depend heavily on future movements in asset prices, since these asset price movements determine the value of loan collateral,

ii. a single set of capital rules (such as the Basle III rules now being imposed on advanced country banking systems) cannot be appropriate for all countries at all times, and undermines the flexibility of national regulators to deal with specifically national problems,

banks’ loan losses in the Eurozone periphery nations are so large that depositors can be repaid in full only by capital injections from the state which affect these nations’ credit rating,

the interaction between banks’ solvency problems and their host nations’ sovereign default risk has created a vicious downward spiral of fiscal and monetary retrenchment, and losses of output and employment, and

this downward spiral is much worse than in a traditional monetary jurisdiction because governments in a multi-government monetary union such as the Eurozone cannot borrow from the central bank

In these important respects a multi-government monetary union is highly dysfunctional compared with the one-currency-per-nation pattern found almost universally nowadays, except in Europe.

I had hoped this week to finish my note on ‘Is UK monetary policy on the right lines?’. However, after writing 2,000 words (and putting together the data for four charts), I have run out of time. This note is therefore numbered 1 ½ rather than 2, and I will return to the exercise next week.The note below concentrates on the years running up to the crisis of 2007 and, more particularly, of 2008, years which passed by the reassuring label of ‘the Great Moderation’. In this period the growth of the quantity of money was consistent with nominal GDP growth of about 5% a year and 2% inflation. Money balances grew as banks expanded their loan assets and ‘bank lending to the private sector’ was the dominant so-called ‘credit counterpart’ to bank deposits. A consistent negative influence on money came from banks’ capital- building. This was necessary of course as banks added to the risk in their balance sheets, and incurred non-monetary liabilities in the form of equity and bond capital. From mid-2007 the pattern of money growth changed radically. From Q3 2008 officialdom placed intense pressure on banks to hold more capital relative to their balance-sheet risks, causing i. a contraction in ‘lending to the private sector’ (in fact, implemented mostly by sales of securities), and ii. a massive programme of capital-raising. These two shocks caused money growth, which has been too high in 2006 and early 2007, to collapse and even threaten to go negative. In early 2009 policy-makers, facing a macroeconomic catastrophe, had quickly to find a means of boosting the quantity of money. (The next instalment of this note – which should be the last – will discuss the role of ‘quantitative easing’ in the resulting macroeconomic salvage effort.)

Rising employment in Britain in recent quarters argues that a recovery is under way, even though it is disappointing by the standards of the past. Official data in recent quarters almost certainly understate the level and rate of growth of output. The understatement may arise because of the difficulty of calculating price indices in an economy dominated by service output, and characterised by extensive product innovation and improvement. (I have no idea how the national income accountants measure the output of Facebook. Twitter and Google.) At any rate, the persistence of employment growth suggests that macroeconomic conditions are normalizing after the trauma of the Great Recession. How should monetary policy now be organized? Do policy-makers need to ‘do more’ to stimulate the recovery? Or is monetary policy already on the right lines?The following note proposes that low and stable growth of the quantity of money remains the key to achieving macroeconomic stability with low inflation in line with the official target. It is suggested that the annual growth in the quantity of money, broadly-defined, should lie between 3% and 5% (or perhaps 2% and 6%) if policy-makers want to maintain consumer inflation of about 2% and moderate output growth at roughly the trend rate (which does not seem to be much above 1 ½% a year and may be lower). For the moment banks seem reluctant to expand their loan assets, despite the continuing verbal assault on them from Mervyn King, the media and others. But money growth at the desired low rate can easily be attained by varying the degree to which the budget deficit is financed from the banks rather than non-banks. Theological debates about ‘quantitative easing’ are unnecessary; they symptomize widespread misunderstanding about how monetary policy can and should be conducted. (This is the first half of a note which will be completed next week.)

What does companies’ monetary behaviour tell us?

QE is widely said to ‘have lost its effectiveness’. As I explained in my weekly e- mail note of 23rd November, QE is to be understoodas‘deliberate action by the state to increase the quantity of money’, while the claim that it is ineffective (or less effective) is equivalent to the claim that increases in the quantity of money have no effect (or a diminishing effect) on the equilibrium level of national income’. In my 23rd November note I reviewed the relationship between changes in the aggregate quantity of money (as measured by M4x) and changes in the UK’s national income over the last 15 years. A key fact emerged, that the increases in both the quantity of money and of national income had been lower in the last five years than for many decades. The vital word is ‘both’. Money and national income have moved together, bang in line with basic theory. On this basis claims of QE’s ineffectiveness are bunkum.This week’s exercise is somewhat different. All agents have a desired level of money holdings (relative to income and the attractiveness of money in comparison with non-money assets), and national income and wealth are at their equilibrium levels only when agents’ actual money holdings are equal to this desired level (i.e., in jargon, ‘when monetary equilibrium prevails’). But in the real world agents’ actual money holdings often differ from the desired levels, and transactions (indeed many rounds of transactions) are undertaken in order to move closer to equilibrium. The value of transactions in bank settlement systems – which nowadays is typically 50 times gross domestic product – includes transactions in capital assets. The main kinds of agent involved in these transactions include households, companies and financial institutions. The focus here is on the monetary behaviour of companies. I show that the ratio of money holdings to bank borrowings of British companies today is much the same today as it was 50 years ago, and that corporate monetary behaviour in the recent cycle has been much the same as in other cycles. To repeat, the notion of QE’s ineffectiveness is bunkum.

The final set of 2011 money numbers from the Bank of England contained a surprise and a puzzle. The surprise was that in the three months to December the M4x money measure fell, whereas earlier in 2011 it had been growing, if slowly; the puzzle was that the fall in the quantity of money occurred despite the Bank’s £75b. quantitative easing operation, which should have led to quite high money growth during the three-month period. In a note on 7th February I discussed these developments and attributed the rather disappointing fall in M4x to banks’ continued shedding of risk assets. The negative effect of this bank “de-leveraging” (as it is called) slightly outweighed the positive effect of QE in late 2011, resulting in the M4x drop. (The de-leveraging could in turn be ascribed to – or blamed on, depending on one’s point of view – banks’ attempts to comply with the Vickers Commission’s recommendations.)Happily, we now have the money numbers for January, which are both more encouraging and less odd. M4x jumped by 1.9%. The annualised rate of M4x growth in the four months since October 2011 (i.e., since the QE announcement) becomes 4.5%, which is fine. The credit counterpart numbers show the clear imprint of both QE and bank deleveraging, which fits with the analysis in the 7th February note. (The public sector contribution to M4 growth in the four months to January was +£53.4b., which isn’t exactly £75b., but is not far from the ballpark implied by the £75b. in the QE announcement. By contrast, M4 lending was -£38.4b. [minus £38.4b.], which is consistent with banks’ shrinking loan portfolios to meet officialdom’s demands.) Given that the Bank of England’s Monetary Policy Committee announced another £50b. of QE last month, the prospect seems to be moderate growth of UK broad money in the rest of 2012 at an annualised rate, say, in the low or mid- single digits. This is not everything in UK policy-making, but it is a reason for expecting UK demand growth to be satisfactory or very satisfactory in coming quarters.